One of the final acts of former Bureau of Consumer Financial Protection (CFPB) Director Richard Cordray before he left to run for Governor of Ohio in 2017 was the issuance of a comprehensive rule governing payday loans, auto title loans, and other small dollar loans. The centerpiece of the rule would have imposed a new "Ability to Repay" (ATR) underwriting standard on providers of these small dollar products for extensions of credit to repeat borrowers. The Rule was scheduled to go into effect in August 2019. In January of this year, however, new CFPB Director Kathy Kraninger announced a Notice of Proposed Rulemaking that would rescind the ATR requirement. This teleforum discusses the logic of the 2017 Rule and the reasons for the CFPB's reconsideration this year.
Prof. Todd Zywicki, George Mason University Foundation Professor of Law, Antonin Scalia Law School at George Mason University
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Operator: Welcome to The Federalist Society's Practice Group Podcast. The following podcast, hosted by The Federalist Society's Financial Services & E-Commerce Practice Group, was recorded on Tuesday, May 28, 2019, during a live teleforum conference call held exclusively for Federalist Society members.
Micah Wallen: Welcome to The Federalist Society's teleforum conference call. This afternoon's topic is on payday lending loans. My name is Micah Wallen, and I am the Assistant Director of Practice Groups at The Federalist Society.
As always, please note that all expressions of opinion are those of the expert on today's call.
Today we are fortunate to have with us Professor Todd Zywicki, who is a George Mason University Foundation Professor of Law at the Antonin Scalia Law School as well as a Senior Fellow for the Mercatus Center. After our speaker gives his remarks, we will then go to audience Q&A. Thank you for sharing with us today. Todd, the floor is yours.
Prof. Todd Zywicki: Thanks, and it's great to be here again. I was asked today to just kind of give an update on what's going on with the so-called Small Dollar Loan Rule that was issued by the CFPB in 2017 and give my sense of what's going on with the rule and the problems with the original rule. So those who will remember back, Richard Cordray was the Director of the CFPB during the Obama administration, and one of the last steps that Director Cordray took as he was exiting the CFPB and preparing to launch his eventually unsuccessful bid for Governor of Ohio was -- the last two big acts he took when he left was first to pass a rule, issue a rule that would have banned arbitration in consumer financial product contracts. That was overturned by Congress under the CRA.
He also issued a rule that governed small dollar loans. The original scope of the rule was very broad. It was finally enacted. It was somewhat narrower. So for example, it excluded most installment loans. But what it did do was impose severe rules governing payday loans, and auto title loans, and similar products that were single payment, not installment loans. The impact of the rule would have essentially decimated those industries.
What the rule did was impose an ability-to-repay test where the central planners of the CFPB essentially not only said that they would have to determine the ability of consumers to be able to repay, but actually provided a template for how consumers would have to repay. What the rule was tied to was essentially what they considered to be heavy users of the product, which they defined as 6 loans within a 12-month period. It made various sorts of other rules. We don't need to go into all the details of what the rule was because of what happened subsequently.
As listeners recall, Mick Mulvaney became Director of the CFPB, or Acting Director of the CFPB, and one of his acts was to announce that they were going to review the payday loan rule, and eventually Kathy Kraninger nominated and confirmed in November 2018 as the permanent Director of the CFPB. In January, the CFPB issued a new rule -- notice of proposed rulemaking. There is some degree of urgency with respect to it because the original rule issued by Director Cordray was due to go into effect in August of this year.
There are two components to the rule. One component of the rule involved payment processing and the ability of lenders to be able to collect from consumers by processing checks repeatedly or electronic debits and the like. That, for now, has been left unaffected. We could talk about that at the end if anybody has any questions about the prospects for that. But for now, the rule that was put in place by the Cordray regime has remained unaffected.
The big effect has been that the CFPB announced in January its plan to rescind the mandatory ability to repay provisions of the rule. And essentially, the bottom line is the original rule was 700 pages long. The revised rule was a couple hundred pages long, the NPRM. And the bottom-line conclusion they reached in that rule, in the NPRM, was that the rule proposed by -- the 2017 rule, I'll refer to it, lacked a robust and reliable evidence to support the rule, and so as a result, they were reconsidering the rule.
So they essentially, for reasons we'll talk about, they could have pretty clearly have concluded that the rule would not have passed muster under the APA, which I think is clear. But instead, they took a more temperate view and basically said that in their judgement, the original rule lacked a sufficient evidentiary basis or a reliable, robust evidentiary basis in order to support the restrictions on choice that were imposed in there for both consumers and lenders for consumers to be able to access small dollar loan products.
The original 2017 rule -- its estimates varied, but one was that it would have wiped out about 60 to 70 percent, maybe 80 percent of the payday loan providers in the country. The CFPB itself admits that with respect to auto title lenders, the number may have been as high as 85 or 90 percent. And so the rule really would have had far-reaching consequences in terms of dramatically reducing access to these products for consumers who are repeat or regular users. The CFPB argued in the 2017 rule, somewhat comically, that somehow or another, they could wipe out two-thirds to 80 percent of the industry, and that that would have left completely unaffected consumers who only use the products on a short-term basis, two or three times a year.
The CFPB also said that the evidence also tended to support the conclusion that short-term users of small dollar credit products such as payday loans, i.e., those who use them less than six times a year, can be -- essentially, that the net benefits are positive, but that long-term users, which they define by the magic number of more than six, it appears, get more cost than benefits from the rule. That, of course, is completely made up and completely arbitrary to draw that line and, for reasons we'll talk about, is not even logically sound as a matter of basic economics.
My comments today will be based primarily on a very extensive comment that I filed with Diego Zuluaga, my colleague at the Cato Institute where I serve as a Senior Fellow as well as my role as a law professor. So let me just say a few things about what is wrong with the 2017 rule and why the NPRM is correct in concluding that there is not a reliable and robust factual basis for the rule that they had issued in 2017. So the first thing that it has to do with is the problem of causation. Basically, the core of the entire rule is—the 2017 rule—was the idea that consumers who use payday loans regularly are mired in a debt trap, which is something they don't really define, but it basically seems to mean, basically, consumers who roll over payday loans from one period to another with some degree of regularity.
Now, what's interesting about that is that a debt trap implies that there's a trap being set by somebody that involuntarily causes somebody to have to roll over their payday loans. And the CFPB in the 2017 rule speculated all kinds of reasons grounded in behavioral economics that we'll come back to that consumers basically -- some consumers underestimate their likelihood of revolving their payday loans once they take the initial loan. But what they're lacking is any mechanism by which this trap supposedly is sprung.
So for example, they identify three possible causal mechanisms. So one would be the possibility that consumers get sued if they fail to pay their payday loans. Well, nobody has reported any evidence that that is something that happens with any degree of frequency. Now, it's possible that that might be, but the CFPB provides no evidence that consumers are regularly sued when they default on a payday loan. Apparently, lawsuits, for some reason, are somewhat common in Utah for reasons that I've not been able to figure out, but otherwise, very few borrowers think that they actually are going to be sued if they don't pay off their payday loans.
A second possibility is that consumers might theoretically be afraid that they might suffer harm to their credit score, and that that might cause them to roll over their payday loans rather than defaulting. Yet, again, there's no evidence for that as well. It turns out that the only data we have, the only evidence we have on that is a study by Ronald Mann, and he found that there is no apparent harm to consumers if they default on payday loans. And it seems primarily, it's because their credit's already stained, that they're people with 520 credit score, and so it's unlikely that they are fearing further harm to their credit score. And in fact, there is no evidence that their credit score is actually harmed. According to research by Victor Stango, a economist, in fact, he found a few years ago that one of the main reasons why consumers use payday loans rather than, say, credit union loans or bank loans is precisely because they know that they don't have to worry about harm to their credit score if they default on payday loans.
So the third theory the CFPB waves its hands about and claims is the possibility that consumers fear debt collectors. And they provide some anecdotal stories about this. Evidence would be overstating it, but they provide some anecdotes and stories and some reports on their complaint database that apparently some consumers are subject to debt collection actions for failure to pay their payday loans. But again, they provide no systematic evidence. Anecdotal conversations I've had with people in the industry suggest that it's by no means common or certainly not uniform. But yet again, we don't have any evidence one way or the other to suggest that consumers roll over their payday loans because of a concern of debt collection.
And that's the big question which is -- they've essentially asked the wrong question at the CFPB in the 2017 rule. Instead of asking why did consumers roll over, they should have asked the question why don't consumers default on payday loans, given the fact that there appears to be very little in the way of adverse consequences from either a lawsuit, harm to their credit score, or perhaps debt collection from actually defaulting. So the CFPB, their attitude in the 2017 rule was to essentially assume the conclusion, which is they have, in italics, I hasten to add, that the payday loan industry depends—that word was in italics in the 2017 rule—people rolling over their loans repeatedly, and they said that the fact that they just don't find it plausible that one of these three explanations, which they think of as the only possible explanations for why consumers roll over, might explain why consumers roll over rather than defaulting.
But they ignored other possible explanations, and I'd like to suggest one possible one that might explain why consumers roll over rather than defaulting, and that is simply to keep access to future payday loans or particularly future payday loans from a particular company with whom a consumer has been satisfied in the past. And what that does is explains why consumers might roll over even thought they could default because the main consequence of default is probably not a lawsuit, harm to your credit score, or collection action. It is getting shut off from further loans from that company, or in places where companies are able to coordinate, from other companies.
That also explains a second issue that the CFPB, because they misspecified the problem, failed to address which is it is, in fact, the case that the default rate on payday loans is very high, as high as 15 or 20 percent, suggests that a lot of borrowers are not intimidated, do not face some sort of in terrorem effect from defaulting on their payday loans, which would be the case if their consequences were really that bad, the involuntary consequences, then the CFPB has no explanation for why the default rate would be so high. And so the absolute centerpiece of the entire payday loan rule was this debt trap notion, but it was completely unproven. And to the extent the CFPB had any evidence for it, it was simply assuming the conclusion. And so I think that's a point on which even if the 2017 rule had stayed on the books, it would have been very hard to survive APA challenge, I think, without any clear causal explanation for what was going on. And I think that's one of the main problems.
I will just add a couple other issues that we could come back to that are problematic and show the poor quality of the analysis that underlay the CFPB's rule. The second problem is a simple economic problem. And the economic problem is that for an economist, the appropriate way of analyzing consumer decision making is what an economist says is at the margin, and that is the moment of choice, a consumer. The flaw in the 2017 rule is that the CFPB's analysis of the consumer decision was not made at the margin. Somehow or another, they thought it should be made in terms of the total cost that a consumer might undertake.
So the real question is not how many times does the consumer borrow? The real question is in any given situation, as a consumer is deciding whether to borrow, do the benefits of maintaining the liquidity for another two-week period exceed the costs? Let me say that again. What matters from an economic perspective is not this sort of toted up number that the CFPB kind of invented as the regulatory question, but the question of whether each time a borrower decides whether to borrow again, do the net benefits of rolling the loan over for another two weeks exceed the net costs? And so what that means is whether it is the first, the third, the fifth, the seventh, or the ninth loan in a sequence, what you have to ask is at each period, do the benefits exceed the costs?
Instead, somewhat ironically, the CFPB claims that the consumers are irrational, whereas the CFPB's analysis commits what economists refer to as the sunk cost fallacy, which is that apparently, in deciding whether to take a seventh loan, a consumer is supposed to consider the cost of the second or third loan that they took two or three months ago. That's just a simple economic error, but the CFPB seemed to be so locked into this debt trap idea that they failed to even understand that what they were supposed to be looking at was the analysis at the margin.
A third problem, and we discussed this in our comment, is the CFPB ran a sort of peculiar simulation as to what the effect of the rule would be. I mean, as I said, one of the peculiar, and unrealistic, and unsupported conclusions of the 2017 rule was the idea that the regulation could wipe out two-thirds or so of all the providers in a market, and that that somehow or another would leave those who only use these loans sporadically unaffected. And they come up with this idea that most consumers would still be within five miles of a payday loan shop, which they consider to be a reasonable distance within the realm of what most consumers travel.
One thing that they don't recognize is that essentially what they've done is change the competitive characteristics of the industry. Essentially, what they've done with that is taken a highly competitive market where barriers to entry are very low and essentially created a number of geographic monopolies. So it could be that now, rather than there being five shops within a five-mile radius, perhaps there's only one shop within a five-mile radius. And as noted above, or as I noted earlier, one of the things that seems to cause consumers to roll over their loans is the fact that they want to get further loans from that provider. By essentially creating a bunch of geographic monopolies, the CFPB essentially is solving that competitive problem for the industry itself.
And so Diego Zuluaga, who I mentioned earlier, my co-author on our Cato comment, did a study of England's similar payday loan regulations a few years ago. And one of the things he found at that time was that the reduction in supply in England was much larger than they had predicted when they actually proposed the rule. Partly, that was because it changed the nature of the consumers who were able to borrow after the rule was passed, but partly, it seems it was likely the cause of dampening the competitive consequences and increasing the concentration of a market that prior to that was very competitive.
I'll say one last thing about the payday loan rule, and then I'll say a few words about the auto title rule and wrap up. One of the most important problems in the original rule and one of the things that I hope that the final rule tackles in a direct way, as the NPRM somewhat is elliptical on it, which is use of behavioral economics in the 2017 rule. It's sprinkled all throughout it what the CFPB speculates is that the reason why they claim with the consumers that some consumers, some minority of consumers underestimate how long their borrowing sequences are going to be is because of various behavioral economics problem biases such as tunneling and other supposed cognitive errors.
Well, behavioral economics, and particularly behavioral law and economics, has not fared very well when actually subject to empirical testing. This rule kind of shows the reason why. It's really just what I've referred to in my scholarship as just-so stories where consumers -- where they basically speculate on something that is supposedly harmful for consumers, and then they reverse engineer various biases that they pull off the shelf of a couple hundred biases that have been identified and claim that that is the explanation for what consumers observe or what consumers actually do.
It turns out that the most comprehensive and only really authoritative study on the behavioral economics hypothesis was conducted by Ronald Mann. And he found that the behavioral economics hypothesis that consumers consistently underestimate their likelihood of rolling over the loans is not accurate. The consumers generally get it right that the errors are unbiased.
And as he filed in a comment to the 2017 rule, even with respect to the misuse of his research by the CFPB in the 2017 rule, what he said was even with respect to consumers who engage in large borrowing sequences, he says even with respect to those borrowers, errors are unbiased even though they are larger. And by unbiased, what they mean is consumers are just as likely to overestimate as underestimate their likelihood of revolving on their loans. And so I think one important thing that I hope will come out in the final rule will be something that recognizes how weak the behavioral theories are that were smuggled into the rule.
The last thing I'll say is the other part of the rule rescinds the auto title regulations. There's much less research on that. There's much less discussion of that part of it, but again, it's basically subject to the same problems. The reality on auto title loans is yes, there is the possibility that some consumers could lose their transportation as a result of taking out an auto title loan, but they failed to run the analysis through. The only study on this that's been done actually misreads their own data and finds that errors on auto title loans are also systematically unbiased and that consumers generally estimate how long it's going to take to them to pay off their auto title loans. There's some discussion about the proper way to measure foreclosures or repossessions on cars.
What I think is interesting is that most studies have concluded that about maybe 8 to 10 percent of auto title loans result in a repossession. Very rarely is that a repossession of the borrower's only way to get to work. It's usually a second car, an older car, and the like. But why I think that is interesting is the same studies find that about 8 percent of auto title loan customers say that -- on a very small sample, said that they would have to sell their car in order to get their necessary cash.
And while I'm a lawyer, and sometimes economist, and not a mathematician, by my calculation, if you sell your car, then you have a 100 percent chance of losing your car. And so to basically say that consumers are not allowed to pawn their car in order to possibly be able to keep it, but instead are required to sell their car hardly seems like you're going to make life better for those people, especially when the repossession rate of about 8 percent seems to be about the same as the percentage of people who say they would have to sell their car to get their cash for what they need.
And so with that, I will turn to questions. I've not talked generally about why consumers use payday loans, why consumers use auto title loans. The evidence is pretty clear on this that people use it for -- they don't use it for frivolous purposes, by and large. They use it for important purposes; groceries, rent, things like that. And so that's not really what the big issue is here, although that does matter in terms of what we said earlier, calculating the benefit at the margin relative to the cost of the loan. So with that, Micah, I will be happy to open up to questions about any of these products generally, or anything about the original rule, or the NPRM specifically.
Micah Wallen: Wonderful. Thank you. Not seeing any question rolling in the queue right away. Professor, is there anything else you wanted to expound on for a bit while our audience comes up with some questions?
Prof. Todd Zywicki: Not really. I mean, the one thing I'll add is that in our comment, we did suggest to the CFPB that they should, at least, perhaps reexamine the payment provisions of the 2017 rule. I think, given the shortage of time—recall that these rules were supposed to go into effect in August—I think that I would have to guess that the new director thought that the ability-to-repay part of the rule was much more problematic and much more in need of an urgent fix. So I don't know. There's some pretty easy ways that they could tinker with the payment provisions that the 2017 rule had and which remain in place, but as of now, they've not expressed any intent to revisit that question.
Micah Wallen: All right, Todd. Well, it doesn't look like our audience has any questions today. If you didn't have any closing remarks, I can go ahead and close this up.
Prof. Todd Zywicki: Nope. I think that I'll do that. But if you're interested in the comment that Diego Zuluaga and I filed, you can find it on the Cato website or certainly in the CFPB docket. I expect fairly rapid movement on this from the CFPB coming up. So thank you, and if anybody online wants to follow up with me offline, I'm happy to answer any questions. Thanks.
Micah Wallen: All right. And on behalf of The Federalist Society, I would like to thank our expert for the benefit of his valuable time and expertise today. We welcome listener feedback by email at firstname.lastname@example.org. Thank you all for joining us. We are adjourned.
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